Inflated asset values, suppressed liabilities – it comes to the same thing

I see from April’s Accountancy that Goldman Sachs and Morgan Stanley have decided to switch from mark-to-market to historic cost accounting for their loan portfolios.

Goldman’s stated purpose is to protect its loan book from swings in value. From memory, they didn’t seem to mind when the swing was upward – even though the market was more contrived than real. But Goldman admits that the change is actually “driven by the more onerous capital treatment.” Regulators have woken up to what we knew all along: volatility of the fair value of loans produces unpredictable swings that demand higher capital ratios. Banks using historic cost accounting are not subject to this.

When it comes to the methodology of reporting fictitious profits there is not a lot of difference between hiding losses by recording assets at artificially inflated values, and hiding losses by suppressing liabilities.

Five years ago I wrote about the Independent Insurance Company, following criminal prosecution of certain directors. Throughout the ‘90s it delivered results that defied gravity: recording phenomenal growth when the rest of the market barely survived.

How did they do it?

The Independent was renowned for its low premiums and small claims reserves (“we don’t need reserves – we settle our claims!”). It was a stock market darling when it floated in 1993. It became the UK’s 9th largest insurance company by 2000, with a market capitalisation of close to £1 billion. Everyone marvelled, but no one could work out how they did it.

They soon found out. Its collapse in June 2001 sent shock waves through global insurance markets, financial services regulators and the City at large. The financial services compensation scheme had to fork out around £365 million to policyholders.

Evidence against the directors showed that the growth mirage was achieved by hiding liabilities. The most obvious liability in any insurer’s balance sheet is unsettled claims, usually classified between (i) amounts required to settle current-period incurred claims; (ii) claims incurred but not reported (IBNR); and (iii) claims incurred but not enough reported (IBNER). But the Independent’s two computer systems, one carrying live claims data, the other holding amounts awaiting entry in the final accounts, had no mutually compatible interface.

“For years many suspected that the emperor had no clothes…

This hiatus allowed many large claims to remain “pending” in IBNER long after being quantified for reserving purposes. It also facilitated suppression of upward adjustments to existing reserves, based on monthly bordereaux from claims handlers. It was estimated that claims liabilities of up to £250 million never found their way into the accounts.

I concluded my February 2007 article: “For years many suspected that the emperor had no clothes, yet nothing was done about it. Will the glaring lessons of the Independent now be taken seriously?”

If we are talking about feigning profitability by suppressing liabilities, and the inability of regulation, governance or audit to prevent it, then no, the lessons have not been learned – unless, of course, legitimising the fraud itself counts as a lesson. When accounting rules permit banks to ignore losses that they “expect”, but haven’t yet written off;when central bankers pretend to “repay” real liabilities with conjured-up fake money, making us victims of the biggest fraud ever inflicted, then no, there is still some way to go.